How to Create a Stock Panic With Two Little Words

[qi:114] When does stock research go from being a helpful insight to the irresponsible equivalent of shouting “Fire!” in a crowded theater? People owning shares in E-Trade are probably wondering that today.

E-Trade (ETFC) has not exactly been a darling of the stock market lately. Its shares had fallen to close below $9 at the end of last week from $23 just four months ago amid news that its mortgage business was getting battered by the subprime mess. (Ironically, E-Trade branched into that business, via its 2001 purchase of LoansDirect, as a hedge against a brutal bear market.)

After Friday’s market closed, E-Trade warned of steeper writedowns this quarter, said earnings wouldn’t meet its previous guidance (while refusing to offer new guidance) and disclosed an SEC investigation into the firm.

So it wasn’t surprising to see analysts downgrading E-Trade this morning — at least three firms lowered their ratings on the stock.

What was surprising was this: One analyst — Citigroup’s Prashant Bhatia — grabbed the lion’s share of the headlines because he went went a big step further: Bhatia predicted that E-Trade had a 15 percent chance of going bankrupt.

Why? Because of “the higher probability of a run on the bank.” E-Trade stock plunged 59 percent Monday to $3.55, its lowest close in more than five years.

Just how much of the more than $2 billion blown out of E-Trade’s market cap Monday as a direct result of Bhatia’s note is hard to say. E-Trade reassured customers it’s taking “prudent measures” and expects to remain “well-capitalized.” A spokesperson went further and suggested that Citigroup’s note was “sensationalism.”

Say what you will about e*Trade’s financial problems, but I have to agree with that last point. I have no reason to doubt that Bhatia was simply trying to warn investors of potential risks, but I wonder how aware he was of the possible ramifications.

All of the mortgage-related problems facing E-Trade had, so far, failed to scare away customers. Just this morning, the company said the number of its retail accounts had risen by 0.7 percent in October and that the assets in those accounts had increased by 4 percent.

But you don’t have to be a financial historian to know that the quickest way to trigger a bank run is to start spreading these two little words: “bank” and “run.” Only two months ago, lines formed outside of UK bank Northern Rock simply because the Bank of England tried to assure investors it would stand by Northern Rock. According to the Economist, it was Britain’s first bank run since 1866.

Given such sentiment, who wants to keep their money in E-Trade when every financial news source is reporting that there may be a bank run on E-Trade? Who wants to hold the stock when you keep hearing that there’s a greater than one in seven chance that E-Trade will go bankrupt?

Credit ratings agencies like Moody’s, S&P and Fitch tend to use Greenspan-like vagueness when describing a company’s problems and risks. Today, Fitch downgraded its rating on the E-Trade asset manager that oversees the CDO investments in question, citing

“concerns regarding the match between the organization’s current competencies and wherewithal with the execution of the firm’s CDO investment management mandates.”

Hardly words to strike panic in the heart. Moody’s held its rating on E-Trade’s senior debt at a junk level, but noted that company should weather the mortgage turmoil.

Such bland qualifications were lost in a lot of the reporting on E-Trade today. Coverage on Bloomberg and The Wall Street Journal was reasoned and balanced. But other sites, where retail investors like to frequent, seemed to be high on the fumes of sensationalism. Here’s the Motley Fool: “How safe is your broker?” And here’s Forbes.com: “E*Trade going out of business?” Those headlines may bring in terrific page views, but they don’t do anxious retail investors any favors.

Like any company caught up in the mortgage mess, E-Trade is tortured by uncertainty. When people don’t know, they tend to assume the worst. If E-Trade’s clients withdraw money first and ask questions later, they will need to find another online bank with brokerage services. Lucky for them, Citigroup (C) can help.

Except, of course, that Citigroup is in the midst of its own upheaval.